Prime time deals

Despite the first recession in 10 years, there was a flurry of memorable real estate mergers & acquisitions in 2001. As big companies competed to become even bigger, mergers occurred throughout the year, touching the multifamily, office, hotel and finance segments.

Sam Zell, chairman of Chicago-based Equity Office Properties (EOP), has always maintained that in the world of REITs “bigger is better.” So Zell must have been smiling when EOP closed its purchase of Menlo Park, Calif.-based Spieker Properties Inc. in July 2001 in a stock and cash transaction valued at $7.3 billion.

EOP has a track record of growing by big acquisitions. After going public in 1997, EOP acquired Boston-based Beacon Properties that same year and then purchased New York-based Cornerstone Properties in 2000. Most recently, Equity Office entered a rather elite club by joining the Standard & Poor's 500 Stock Index on October 9, 2001.

At the time of the merger last year, Zell stated the Spieker purchase was consistent with the strategy that Equity Office has articulated since it went public in mid-1997. The company wants to build up a greater critical mass of Class-A office buildings in markets with high job-growth potential and significant barriers to new development. Certainly, the Spieker deal gives EOP even greater geographic diversity than it already enjoyed, since Spieker was the largest West Coast office/industrial REIT. EOP has also expanded its board of directors to include former Spieker chairman Ned Spieker, and former co-CEOs Craig Vought and John Foster.

Today, EOP is the largest publicly traded owner of office space in the country, toting a $12 billion market cap, with interests in 774 buildings totaling 128.2 million sq. ft.

However, Wall Street analysts are lukewarm on EOP's stock these days. They worry that the company is overly exposed to weaker West Coast office markets such as San Francisco and San Jose, Calif., which accounted for nearly 25% of EOP's net operating income growth in 2001.

“We believe the market has reduced the credit previously ascribed to EOP for the 2001 acquisition of Spieker Properties, given the sharp decline in West Coast office occupancy and rental rates,” says David Kostin, head of REIT research at New York-based The Goldman Sachs Group Inc.

He also is concerned that the challenging leasing environment on the West Coast could bring down EOP's share price, which in mid-February was at a premium to book value. As of Feb. 27, the company's stock price was $28.86, down from its 52-week high of $33.19. Its 52-week low was $26.20.

Now that the Spieker merger is more than six months along, David Loeb, the managing director of real estate at Friedman Billings Ramsey in Chicago, also expresses concerns about the deal. “Accretion from the Spieker merger may be lower than management estimates if expected cost savings and synergies are not achieved,” he says.

That's not to say EOP is falling short of its performance targets. In its latest reporting, EOP met consensus expectations by earning $0.82 per share for fourth-quarter 2001 excluding charges, which was 9.3% higher than fourth-quarter 2000. It reported funds from operations (FFO) of $2.91 per share for all of 2001, up from $2.86 per share in 2000. However, EOP management lowered its 2002 earnings guidance from a range of $3.40-$3.50 per share to $3.10-$3.30 per share.

Still, thanks largely to EOP's sheer size and the prestige of being on the S&P 500, analysts such as John Forrey, managing director of Merrill Lynch's global securities research and economics group, are committed to the company for the long term. “We see the company as a core holding in the REIT sector given its strong credit profile and bellwether status among REITs,” Forrey says.

Stuart Seeley, head of REIT research at New York-based UBS Warburg, has concerns about EOP's ability to fight through an office-leasing downturn. “There is no question that occupancy in EOP's portfolio deteriorated more rapidly than we anticipated,” he says.

EOP continues to recycle its assets and tidy its balance sheet to focus on office properties. In fourth-quarter 2001, EOP sold 4 million sq. ft. of the industrial portfolio it acquired in the Spieker transaction to Chicago-based RREEF Funds for $213 million. EOP still is left with about 6 million sq. ft. of industrial space from the Spieker portfolio. Apart from the Spieker purchase, EOP sold all but one of its parking facilities last year for about $271 million.

Spieker's portfolio was nearly unencumbered with debt at the time of the acquisition. In total, EOP is about 43% leveraged. It did acquire a $614 million development pipeline from Spieker concentrated mostly in Northern California, and representing about 2% of EOP's net asset value. The pipeline is about 41% pre-leased, and EOP has reduced its average return expectation from the mid-teens to about 12% given the slowed leasing environment.

Ross Smotrich, REIT analyst for New York-based Bear Stearns, has lowered Equity Office's FFO growth target for 2002 to $3.19 per share from $3.42 per share. His reasoning? The REIT's 2001 total growth was driven by a confluence of events that might not be repeated in 2002 — 8.3% net operating income (NOI) growth, a 29% increase in portfolio square footage due mostly to the acquisition of Spieker, and above-average termination fees in the fourth quarter. It doesn't help that the occupancy of EOP's portfolio fell from 95.2% in fourth-quarter 2000 to 92.1% in fourth-quarter 2001.

Analysts worry the trough could deepen, too, since nearly 25% of EOP's leases that expire in 2002 and 2003 are in San Francisco, San Jose, Seattle and Boston. But EOP expects the pace of leasing and absorption in these key markets to pick up in the next two years, while new office completions will almost certainly slow.

GE Capital acquires Heller Financial

One of the surprise finance mergers of the year was Stamford, Conn.-based GE Capital's $5.3 billion purchase of Chicago-based Heller Financial, which was finalized in October 2001. The deal was big even by the standards of corporate parent General Electric Co. It quickly ranked as GE's second-largest transaction ever, behind its mid-1980s purchase of RCA Corp. It also helped salve recent wounds from GE's own failed acquisition for Honeywell International Corp., as well as GE Capital's unsuccessful bids for CIT Group Inc. and Finova Group Inc.

GE paid $53.75 per share for Heller's outstanding common shares, and agreed to buy all of Heller's Class-B shares from Japan-based Fuji Bank Ltd., which represented about 52% of Heller's ownership. No doubt GE recognized the trend of Japanese banks selling off overseas assets to raise cash in the wake of Japan's economic troubles.

The deal dynamics sound simple enough: GE Capital gained instant entry into new business lines, including the so-called “middle-market” of commercial real estate finance where loans often average between $5 million and $30 million, while Heller gained access to a vast new source of capital.

According to Denis J. Nayden, GE Capital's chairman and CEO, the deal was a strategic fit. GE gains access to golf course and vacation ownership financing it has never pursued, as well as a talented team with established customer relationships. “Both companies benefit. The Heller originators have more products to sell due to our depth and breadth of product offering,” he says. “Additionally, the employees get the benefit of GE's training and initiatives,” says Nayden.

The deal is not expected to substantially change the way real estate financing gets done. But analysts point out it can only make GE Capital a more solid all-around player in borrowers' eyes.

“The merger went very smoothly in large part due to our similar cultures and GE Capital's vast experience in integrating acquisitions,” says Nayden.

For example, Michael Rowan, formerly of Heller, heads up GE Capital's Specialized Industries Group, with mostly ex-Heller employees reporting directly to him due to their experience in these product types. “We merged the prior GE Capital Special Products into Mike's group to achieve the desired synergies from this acquisition,” says Nayden.

However, a few defections have occurred from the Heller side. Most notably in January 2002 former Heller real estate group president John Petrovski and two managing directors left to join a new real estate finance unit of New York-based Merrill Lynch & Co. called Merrill Lynch Capital. Petrovski had been with Heller since 1987.

Merrill Lynch set up the new unit to finance “middle-market” deals of $5 million to $30 million, essentially the same turf that Heller had also carved out. Petrovski says he wants to generate up to $500 million in such deals in 2002.

Archstone Communities buys Charles E. Smith Residential

In the apartment business, mergers in recent years have made the biggest players much bigger. The latest example is Englewood, Colo.-based Archstone Communities Trust, a REIT that began life in the mid-1990s as two separate REITs — Security Capital Pacific Trust and Security Capital Atlantic Inc. — controlled by Security Capital Group. The Archstone moniker was adopted after the two entities merged in 1998.

Last October, Archstone finalized its acquisition of Washington, D.C.-based Charles E. Smith Residential Realty for $3.6 billion, making it the largest apartment transaction of 2001. The combined entity, now known as Archstone-Smith Trust, is the third-largest apartment REIT in the nation with a market cap of about $9.5 billion and 225 apartment communities across the country totaling some 80,000 units.

Essentially, there are two types of properties in the combined portfolio. The Archstone brand name is attached to garden-style properties and the Smith name is used for the high-rise properties that Smith brought to the merger.

According to R. Scot Sellers, chairman and CEO of Archstone-Smith, the merger is consistent with Archstone's long-term goal of concentrating its investments in excellent locations in markets where it is difficult to build new apartments. “We believe it is well-documented that supply-constrained, protected markets produce the best long-term growth and returns to owners,” Sellers says.

Perhaps most important is the red-hot Washington, D.C., market that now represents 32% of Archstone-Smith's portfolio. He notes that the city is a great market to be in during an economic slowdown due to its stable mix of government and private-sector jobs.

“As a result, even though the transaction was slightly dilutive in the very short term, we were confident our significant presence in the greater D.C. market would enhance our growth rate not long after the transaction closed,” he says.

One leading REIT analyst agrees. Due to the company's large Washington, D.C., presence, Archstone-Smith was one of the few apartment companies in the nation that managed to produce discernibly positive revenue and NOI growth during the fourth quarter of 2001, says Steve Sakwa, a senior analyst with New York-based Merrill Lynch.

But not everyone is convinced that the company can keep up its results in 2002. Even though Archstone-Smith affirmed its guidance for 2002 growth in its recent conference call, Robert Stevenson, a REIT analyst with New York-based Morgan Stanley, speculates that the company might have to lower its sights as the year progresses. “We worry that at some point in the next few quarters, Archstone-Smith might be forced to lower guidance at a time when the rest of the sector is maintaining, or potentially raising, estimates,” he says.

One of the goals of the acquisition, says Sellers, was to “enhance the professionalism” of the apartment industry and the general real estate industry. “Public real estate companies have a tremendous opportunity to be a highly desirable investment vehicle for pension funds and private investors,” he says. “As we become more like the best-run operating companies in Corporate America, we move ourselves further along the road toward the realization of that vision, which we are very passionate about.”

That may be a tall order, given the fragmented nature of the nation's apartment ownership, but Sellers is convinced he has the tools at his disposal. He said the company has brought a number of innovations to the industry, including the first national apartment brand, a central customer call center and an online leasing capability. “These are all areas where we have led the way in industry improvements, and we are excited about many of the new innovations we are working on,” he says.

Integration is the key to making any merger successful. Sellers notes that the biggest challenge with the Smith acquisition is melding the internal technology platforms of the two companies.

“The most challenging issue to date has been the rapid integration of a number of large and very complex systems that each company has, from accounting and information technology to external reporting,” he says. “This has gone very smoothly despite a very rapid integration time frame.”

Sellers expects the apartment M&A trend to accelerate. “I can't accurately predict if this will occur in 2002, or later, but it will occur,” he says.

Blackstone Real Estate Advisors buys Homestead Village

Coming off its best profit-making year ever in 2000, the hotel industry was bound to slow down in 2001. However, no one could have predicted the huge dip in revenue per available room (RevPAR) and occupancies caused by the recession and the fallout from the Sept. 11 terrorist attacks.

Enter New York-based Blackstone Real Estate Advisors, a heavyweight private real estate investor known for making contrarian deals in down economic times. In November 2001, it plunked down $740 million to buy Atlanta-based Homestead Village, a leading extended-stay hotel chain, from Security Capital Group. The company officially was renamed BRE/Homestead Village LLC. Blackstone made the purchase with $480 million in cash, assumed $145 million of liabilities and issued a $115 million, five-year note to Security Capital. Blackstone also earned a $160 million discount from the original offering price due largely to the aftermath of Sept. 11, which resulted in a decrease of the initial asking price.

Soon after Security Capital sold the hotel chain, the company agreed to sell its remaining real estate operations — which include storage facilities, neighborhood retail centers and parking facilities — to GE Capital for $4 billion.

Blackstone senior managing director Jonathan D. Gray is no stranger to big hotel deals. He managed Blackstone's 1998 acquisition of The Savoy Group of luxury hotels in London. To Gray, the Homestead deal presented a long-term upside opportunity.

“We were attracted by the fundamentals in the moderate-price, extended-stay sector and Homestead's position within that sector,” says Gray. Due to a high percentage of long-term guests, extended-stay hotels tend to enjoy more stable occupancies. They also produce higher profit margins because of the limited amenities they provide.

“As for Homestead, we liked the fact that the assets were newly built, well-located and came with a talented management team in place,” Gray says. While the hotel industry in general experienced one of its worst short-term slumps in history after the terrorist attacks, the extended-stay segment remained fairly strong. “In addition, the business held up remarkably well post-9/11 — running 71% occupancy the week of Sept. 22 — and that gave us confidence to move forward,” he says.

However, Gray and the Homestead management team, led by president and CEO Gary A. DeLapp, face a steep hill to climb. “The biggest challenge to the acquisition is the current operating environment for hotels in the U.S.,” he says. “Fortunately, we acquired the company post-9/11 so we were able to be very conservative in our projections.”

Mark Woodworth, a noted hotel analyst and executive managing director of the Hospitality Research Group, the Atlanta-based division of San Francisco-based PKF Consulting, notes that both Blackstone and Security Capital had something to gain from the transaction.

“From all indications, Security Capital wanted out of the extended-stay hotel business, so they obviously accomplished that goal. Blackstone gets a meaningful critical mass — 112 properties with 17,000 rooms — with good distribution in 37 markets with which to grow the system,” he says. “The properties are all relatively new and have some of the best curb appeal in the more moderately priced tier of the extended-stay segment.”

He notes that one key to the deal was Blackstone's ability to acquire Homestead's assets for well below replacement cost. Now, Blackstone can grow the business to realize future gains, given that demand for this property type is both growing and under-served in many markets.

“Homestead has an established critical mass with meaningful distribution,” Woodworth says. “Market dynamics are such that there is new opportunity to grow the Homestead system, both through ground-up development as well as via the acquisition of single assets and small local/regional chains.”

Blackstone also has access to capital, which will enable the company to capitalize on acquisition opportunities that will continue to evolve as the industry recovers.

“I expect that Homestead should very much be a long-term brand in this segment of the lodging industry,” Woodworth says. “Time will certainly tell. If Blackstone is able to affect solid, consistent operating standards and effective marketing practices at the unit level, I believe that its timing may actually have been perfect.”

That timing could also make the Homestead deal one of the last the industry sees in while, or at least until the economy improves. Notes Gray, “I would speculate that lodging M&A would be slow in 2002 given the challenging financing environment and weak operating performance in the sector.”